The difference between an American and European option is that the American option can be exercised at any time,
whereas the European option can be liquidated only on the settlement date.
The American option is "continuous time" instrument, while the European option is a "point in time" instrument.
Options are just tools to evaluate underlying assets contingent to a specific event, or viceversa to understand
the probabilities implied in the price that an event will happen.
The strength of the results is directly correlated to the quality of the inputs used in the model.
An option is a derivative that specifies a contract between two parties for a future transaction, known as an exercise,
on an asset at a reference price. The buyer of the option gains the right, but not the obligation,
to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.
There are two types of option. A call option gives the holder the right to buy the underlying asset
by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset
by a certain date for a certain price. The price in the contract is known as the strike price.
The date in the contract is known as the expiration date. European options can be exercised only on the expiration date.
American options can be exercised at any time up to the expiration date.
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This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.
Assumptions of the Black and Scholes Model:
1) The stock pays no dividends during the option's life
Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.
3) Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.
4) No commissions are charged
The Black and Scholes Model:
Delta is a measure of the sensitivity the calculated option value has to small changes in the share price.
Gamma is a measure of the calculated delta's sensitivity to small changes in share price.
Theta measures the calcualted option value's sensitivity to small changes in time till maturity.
Vega measures the calculated option value's sensitivity to small changes in volatility.
Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model.
5) Interest rates remain constant and known
The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.
6) Returns are lognormally distributed
This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.
Applications of B-S PDE
We can compute
vanilla call and put options,
binary call and put options,
call and put options on the foreign exchange market.
We cannot compute analytically but can solve B-S PDE numeric
options with non-standard payoffs,
American call and put options,
some other complicate contingent claims.
The Black-Scholes option pricing model is a highly regarded theoretical option pricing formula in significant use today. Traders should be familiar with how it works.
The Black-Scholes option pricing model may be the most used and best known theoretical option pricing model among several developed in recent decades. In simplest terms, it is a mathematical formula intended to determine the price of an option (or warrant) relative to multiple inputs, like a stock’s price, or volatility, or the risk-free interest rate. Said another way, it’s a tool that tells traders if an option is overvalued or undervalued at its current price.
One of the inputs - a stock's volatility – is sometimes arbitrarily determined
It can overvalue deep out-of-the-money calls, yet undervalue deep in-the-money calls.
It assumes the risk-free rate and the stock's volatility are constant.
It assumes stock prices are continuous and involatile
It assumes a stock pays no dividends
It assumes the option will not be exercised until expiration day
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